Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Wednesday, February 5, 2014

A Lousy Investment

The current account balance of a
nation is akin to phenomena like trans fats, water-boarding and West Nile Virus
in the fact all have entered the popular lexicon, very few people know exactly
what they are, but most are pretty sure that experiencing any of them would be
quite unpleasant. Despite the well-documented risk of consuming more than one
can produce domestically, the United States has chronically rung up a deficit
in its current account since the early 1980s. The country has gotten a “pass”
on this profligacy from creditors given it is home to the world’s largest
economy, its transparent and liquid financial markets, and the dollar’s status
as the de-facto global reserve currency. As evidenced by recent events in
Turkey, emerging economies are not so fortunate, with financial markets
eventually punishing countries that are perpetually in the red. Yet the great
economic axiom of there is no free lunch
holds true; there is genuine risk should the U.S. fail to address its
imbalances.

A Quick and Dirty Lesson in International Economics

A most basic definition of a
nation’s current account is that it measures the goods and services a country
buys from abroad versus those it exports. A country which buys more than it
sells will run a current accounts deficit (yes there are additional buckets
that comprise the current account tally, but as to not bludgeon the reader with
national account minutia, those will be ignored for now). In the past
generation, the U.S. has transitioned from a creditor nation to the world’s
largest debtor. One reason for this is the country’s dependence on foreign oil.
While the U.S. is still one of the world’s top producers of crude, the energy
required to fuel its suburban-living, SUV-driving lifestyle means it has had to
import approximately half of its oil needs, although the number is presently on
a downward trend thanks to the Greenies’ favorite bugaboo: hydraulic
fracturing. Not coincidentally, America’s persistent current-account deficits
has roughly coincided with the country becoming a net crude importer.

Another contributing factor has
been the relocation of massive amounts of manufacturing capacity to low-wage,
namely Asian, countries. In one of the
most blatant ironies in modern economic history, the revenues generated by
foreign (and domestic) firms hawking a range of cheaply built products were
funneled back into U.S. financial markets for safe keeping, which in turn
helped keep interest rates low (high demand and subsequent high bond prices
push yields lower), thus spurring additional credit-fueled consumption.

On The Flip Side

Even less known than the nuts and
bolts of the current account is that there is a (mostly) offsetting account
measuring capital flows into a country. If a country consumes more than it produces,
it must borrow the funds from abroad to pay for the difference. This is
especially true in the United States, which, when including government
accounts, doesn’t bother with anything as trivial as building up savings.
Without a national piggy bank to dip into, and with consumption far outpacing
domestic production, the U.S. must make up the difference with funds loaned
from our buds in Beijing, Tokyo, Riyadh and Dubai.

Fortunately for spendthrift policy
makers….and their overindulgent constituents….the U.S. remains atop the list of
the most attractive destinations for risk-adjusted investment returns. Despite
many shortcomings including sluggish GDP growth, chronic joblessness, an uptick
in regulations, lousy coffee and a mediocre national soccer team, the country
still has liquid, well-regulated capital markets, the rule of law and the
reputation for paying its bills.

“You Spent It on What??”

Just like with consumers and
businesses, financing certain purchases at times can be prudent for a country.
It all depends upon how the borrowed funds are spent. If they are used for
investing in high value-added endeavors such as modernized infrastructure, increased
industrial capacity and education, then the return on investment could merit
the financing costs. This is a reason why many….not all….emerging markets get a
free pass for temporarily running current-account deficits. In order for a
country to upgrade from goat herding, strip mining and small-arms manufacturing
to a more complex, value-added product based economy, it must first import the
capital goods necessary to retool its medieval industrial capacity. That
entails running deficits until the high-margin exports start flowing.

So how has the United States
invested its bounty of foreign inflows? Clearly not in infrastructure, given
the nation’s crowded freeways and crumbling bridges, nor in education as
evidenced by the country’s steady slide down global science and math rankings.
It is true that the U.S. is home to a number of hyper-efficient, cutting-edge
factories, but the manufacturing sector has contracted over the years to the
point that it no longer provides the pop
to the overall economy when output is buzzing. Nope, instead the country has
gone on a binge of buying financial assets and speculative real estate in
crappy locales such as Las Vegas, mosquito-ridden
coastal towns and down-market ex-burbs.

During the boom, policy makers and
business leaders alike thought they had stumbled upon the perpetual motion
machine; cheap credit funds housing expansion, home-buyers demand even more
gadgets to cram into their man caves and three-car garages, which in turn fattens
the wallets of purveyors of those goods…along with those of numerous housing-centric service
providers…allowing them all to partake in the virtuous circle. But one can only buy so many flat-screen TVs. Once
the sugar-buzz of a housing spurt wears off…which it inevitably does…if there
is no underlying industry (ideally export-oriented) to pick up the slack, the…pardon
the pun….house of cards collapses. As
it did. A robust housing market should be the consequence of a strong economy, not the source of one.

The influx of foreign funds also
flowed freely into U.S. financial markets. This lowered the cost of capital
across the economy thanks to treasury purchases, goosing aggregate demand and
driving corporate profits higher. Some
of this foreign money went directly into equities markets, joining domestic
investors as they chased indices to record highs.

In theory, robust demand for shares
can provide corporate boards with funds necessary to expand capacity and invest
in new projects. This concept is one of the underpinnings of the Fed’s multiple
iterations of quantitative easing. The only problem is that it hasn’t worked.
Instead of building new factories in the borderline Soviet expectation that
increased supply will somehow spur demand, firms have squirrelled away these
funds and will likely not deploy them on any large scale until there is greater
evidence that economic growth finally has hit the afterburners and demand for their
products returns.

Capital Stock: The Missing Link

A key contributor to economic
growth is increasing productivity. And a sure-fire way to increase productivity
is to have glitzy new factories and cutting-edge technologies deployed across
society. While there are certainly such
examples in America, over the past four decades investment in nonresidential
fixed assets has been on a downward trend. Much of that is attributable to the
transition to a service-based economy. One can argue that as the world leader
in exporting services, the country does not need levels of investment required
during an earlier era. The contrarian view, however, is that a country that makes
stuff, value-added stuff and in large
quantities, should have a bright future.

As seen in the chart below, the
trend for investing in private sector equipment has steadily fallen over the decades.
In the meantime, residential real estate went on a tear, far outpacing overall
economic growth. As stated earlier, such gains proved ephemeral. In a tragically fitting irony, yield-hungry
investors, spurred by the Fed’s extraordinary monetary policy, made
cash-investing in depressed real estate markets a borderline national pastime
in the aftermath of the crisis, essentially, doubling down on a sector that
does nothing to increase competitiveness.

Giving Trickle-Down Economics A Bad Name

So when it comes to preparing for
the future, the U.S. is a lousy investor. What’s worse, rather than squandering
its savings (it has none) on dud endeavors like real estate and stock
speculation, it is borrowing money from abroad to do so. The safety of the
country’s financial markets has been a strong competitive advantage versus even
other developed economies. But eventually, if the return on investment is not there, foreign governments, sovereign
wealth funds and private investors will find other, higher-yielding
destinations. Should that occur, the
country’s ability to get away with consuming more than it produces would be
threatened and any attempt to raise interest rates to win back foreign capital
would add yet another headwind to this unprecedented era of sputtering growth.

Whether one is a supply-sider or
not, it is evident that the concept of trickle-down economics only works when
the titans of industry put their wealth to work by investing in factories and
office space, hiring workers and increasing productivity. Yet in the wake of the financial crisis and
policy responses it triggered, there has been no wealth effect sending positive
shockwaves through the economy as promised….unless one considers Aspen
hoteliers, stock brokers and Manhattan real estate agents. This backdrop of a recovery benefiting only the very few who have large amounts of
paper assets makes the recent State of the Union speech, grumbling about income
inequality, all the more laughable. This administration’s…and the Fed’s…. misguided understanding of
investment incentives and requirements for durable economic growth have only aggravated
the income gap.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.